Basel Faulty?

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Basel II may at long last be coming soon to a bank near you. And for better or worse, the new international bank regulatory regime promises to shake up the loan market.

The accord sets new guidelines for determining how much capital banks in 13 developed countries around the world must hold in reserve. It is scheduled to take effect in its most advanced form in 2008, nine years after initial work on the standards began. Because the new guidelines are more risk-sensitive than the existing ones, it has been widely expected that Basel II will make lower-risk bank lending cheaper, since banks will be required to hold less capital against such assets. That's expected to produce lower-cost loans for large, healthy companies.

On the other hand, higher-risk borrowers could see costs rise, because banks that lend to them would have to hold more capital in reserve under the new regulatory setup. In fact, our survey of finance executives (see "Last Banks Standing") found that 7 percent of the respondents expect Basel II to increase their cost of capital, while less than 1 percent feel that it will decrease it. And the new rules could put smaller banks that aren't covered by them at a competitive disadvantage, which could mean high-credit-quality borrowers may want to consider shopping for bigger providers (see "Attention Shoppers," below). More broadly, banking experts aren't uniformly convinced that the new approach will be good for the U.S. banking system.

Proponents of Basel II say it's needed to rationalize the current reserving requirements, which treat loans to junk borrowers as no more risky than loans to A-rated credits. They also point out that the world's largest and most highly developed banks already use sophisticated internal risk models that take such disparities into account and argue that Basel II is needed simply to keep pace with real-world practice. Critics counter that by inviting banks to develop their own reserving models, as Basel II does, regulators will be injecting new risk into the U.S. banking system and perhaps threaten its stability. "The difficulty is that the assumptions going into these advanced models do not always hold," warns Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College. He cites the experience of hedge fund Long-Term Capital Management, which had to be bailed out by a consortium of banks and investment houses to the tune of $3.6 billion in 1998 after its sophisticated fixed-income arbitrage models came unraveled. "The more sophisticated the models, the more likely they are, I think, to be vulnerable," Papadimitriou says.

Basel II is being developed by the Basel Committee on Banking Supervision, an arm of the Bank for International Settlements, although final rules are the responsibility of banking regulators in each of the 13 participating countries and those additional countries that voluntarily sign on.

Progress in the United States was slowed early this year when a dry run by nearly 30 of the country's largest banks revealed that minimum capital requirements would go down by nearly 50 percent at some institutions and up by 50 percent at others. U.S. regulators were taken aback not only by the wide dispersion of the numbers, but also by the degree of the declines indicated for some banks. In response, they postponed their notice of proposed rule-making — which was to outline exactly how Basel II should be implemented in this country — until this fall.

Seeking Reassurance

Federal Reserve Board Governor Susan Bies says that once regulators have a good understanding of the reasons for the results of the dry run — technically, quantitative impact study 4, or QIS4 — they should push forward. She notes that other opportunities to validate the framework are built into the implementation process, including a one-year parallel running period, in 2007, in which U.S. banks adopting Basel II would continue to be bound by the old capital rules, followed by a two-year period during which a floor would be imposed on how far capital would be permitted to decline as a result of the new rules.

"Some of these variations may actually reflect different risk levels at different banks," says Bies. "All banks don't run their businesses the same way. Over time, they have gotten much more business-line focused. There is less similarity than there used to be from one institution to the next, which means this sort of variation may be appropriate."

While the potential for sharp reductions in regulatory capital unnerved some regulators, the proposed regulations have some safeguards built in. True, each bank is allowed to develop its own risk and capital-reserving model, but Basel II also provides for a supervisory review by regulators, who, if they are uncomfortable with a bank's model, can override it. Also, in the first and second years of implementation, banks must maintain their minimum capital requirements at 90 percent and 80 percent, respectively, of what they were under Basel I. In addition, the findings from QIS4 appear to have convinced U.S. regulators to continue to enforce the existing minimum tangible-equity-to-asset requirement, or leverage ratio, which keeps a floor on regulatory capital. The leverage ratio requires banks to hold, at a minimum, capital equal to 5 percent of book assets.

Meanwhile, there are business reasons why banks may not choose to reduce their regulatory capital levels as much as Basel II might allow. Both the original and new Basel accords require banks to hold so-called tier-one, or "core," capital (which refers to the most reliable and liquid capital on the bank's balance sheet, primarily equity), equal to 4 percent of their risk-weighted credit exposures, and total capital equal to 8 percent of their risk-weighted credit exposure. However, Basel II gives banks more flexibility in calculating their exposure to credit risk and operational risk.

Yet Tanya Azarchs, a bank-rating analyst at Standard & Poor's, notes that regulators in most developed countries require banks to hold tier-one capital reserves equal to 6 percent of their credit exposures if they wish to be classified as well capitalized, as the vast majority, for a variety of business reasons, do. Consequently, "all the big banks stay well above the 6 percent tier-one threshold," says Azarchs. "The average ratio is probably 7.5 percent or 8 percent around the world. So even though Basel II might give them the regulatory authority to hold less capital, it's not clear that banks would take full advantage of that opportunity. It's uncomfortable to think they really could, but I doubt they will. They have their own internal levels of prudence."

Going Private

Uncertainties like these make it difficult to predict the degree to which corporate lending might change once Basel II is implemented. Nonetheless, banking analysts have pinpointed some areas where change is most likely. For example, companies with investment-grade credit ratings may find it easier to get bank loans at competitive rates. In the past, banks have shied away from lending to highly rated credits because Basel I forced them to hold just as much capital against those loans as they did against loans to lower-rated credits with bigger profit margins.

If loan pricing moves enough, some corporations may find that they can finally raise capital more cheaply by borrowing from banks than by issuing commercial paper. They also may find better deals on loans backed by collateral, since the new rules give banks more flexibility to reduce capital reserves on such deals.

Industry consultant Karen Shaw Petrou, managing partner of Washington, D.C.-based Federal Financial Analytics Inc., says lenders also may find it more advantageous under a Basel II regime to use other credit-risk mitigation techniques, such as guarantees, portfolio insurance, and credit derivatives. Finally, she says, banks operating under Basel II may become less interested in offering one-year revolving lines of credit, against which they didn't have to hold regulatory capital under the original Basel accord but now will. When lines of credit are available, they may be more expensive.

To date, few corporate finance executives have been paying more than peripheral attention to the Basel II birthing process, though that could change as implementation draws nearer. "I haven't paid a lot of attention to it, although obviously, if the regulatory capital requirements change, it could have an effect on pricing for banks, and we'll be following that," says Dessa Bokides, vice president of finance and treasurer at $5 billion Pitney Bowes Inc.

Still, she doesn't expect Basel II to significantly change how or where Pitney Bowes raises money or which banks it works with. "My gut tells me it probably won't change those types of items dramatically. I remember when Basel I was put in, and that is kind of what happened."

But that doesn't mean corporate borrowers can just ignore the change in regulatory regime, notes attorney Gregory Lyons, chairman of the financial services practice at Goodwin Procter LLP in Boston. "I would recommend that they look at their own credit rating, which will become more important than it has been in the past," he says, "and reevaluate the viability of borrowing versus other forms of raising capital."

Randy Myers is a contributing editor at CFO.

Time to Start Looking For a Bigger Bank?

Attention Shoppers

Unlike the other nine countries participating in Basel II, the United States is not requiring all of its banks to comply with the new accord. Only the nation's biggest banks — probably the top nine at the moment — are required to adopt it, though another dozen and a half or so are expected to do so voluntarily (see "The Basel Banks?" below). In addition, unlike regulators in other countries, U.S. banking agencies are requiring U.S. banks to adopt only the most complex and sophisticated form of Basel II, known as the "advanced" model. Banks in other countries can choose between the advanced model and the so-called "foundation" model, which is slightly more prescriptive in calculating risks, and the "standardized" model, which affords even less flexibility in calculating minimum capital reserves. Those that choose the standardized model can actually begin using it in 2007.

In the United States, smaller banks are worried that they'll be at a competitive disadvantage once their bigger competitors adopt Basel II, because the big banks will be allowed to hold less capital against lower-risk assets. In response, U.S. regulators are now contemplating what some in the banking industry have dubbed Basel IA — a refinement of the original Basel capital accord for smaller banks that is less complex than Basel II but still more sensitive to risk than the current arrangement. Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc. in Washington, D.C., predicts that no matter what happens with Basel IA, the Basel II banks will develop a bigger appetite for lower-risk business — even as they might put a higher price tag on higher-risk business. Accordingly, she says, CFOs and treasurers might want to shop now for new banking relationships, "before their banks present them with offers they want to be able to refuse." — R.M.

The Basel Banks?Banking regulators haven't specified which U.S. banks and thrifts, or even how many, must comply with Basel II. Their guidelines suggest that roughly the first nine institutions on this list must comply, while the rest are likely to adopt it voluntarily.

Bank

Assets (in thousands)

1 Citigroup

$1,547,789,000

2 Bank of America

1,251,037,147

3 JPMorgan Chase

1,171,283,000

4 Wachovia

511,840,000

5 Wells Fargo

434,981,000

6 HSBC North America Holdings

372,555,243

7 Taunus (Deutsche Bank)

366,293,000

8 Washington Mutual

333,742,732

9 U.S. Bancorp

203,981,000

10 Suntrust Banks

168,952,575

11 Countrywide Financial

158,617,821

12 Citizens Financial Group

148,491,012

13 ABN AMRO North America Holding

145,024,570

14 National City

143,975,359

15 Golden West Financial

112,587,849

16 BB&T

105,835,324

17 State Street

104,275,118

18 Fifth Third Bancorp

103,159,676

19 Bank Of New York

103,110,000

20 Keycorp

91,010,081

Source: Federal Reserve, SNL Financial. Thrift data as of March; bank holding company data as of June 30.